Fiscal Consolidation, Social Sector Expenditures and Twin Deficit Hypothesis: Evidence from Emerging and Middle-Income Countries

Abstract

Following the present scale of fiscal imbalances, governments often implement fiscal consolidation programs to restore macroeconomic stability. This paper empirically explores the connections between social expenditure, current account and fiscal consolidations using the system-GMM estimator, on a panel of 23 emerging and middle-income countries for the 2009–2018 period. Our results confirm that government social expenditure decreases once fiscal austerity measures are implemented, practically when they are spending-driven. Fiscal consolidation may hurt important social expenditure allocation mainly on education and health components. Furthermore, we find that fiscal consolidation improves the current account deficit, providing support for the twin deficits hypothesis. These findings indicate that fiscal consolidation will eventually contribute to medium- and long-term external debt stability through the current account improvement. However, the exclusion of key growth determinants such as human capital can lead to many inefficiencies such as weak competition in the provision of social services (Jafarov and Gunnarsson in Government spending on health care and education in Croatia: Efficiency and reform options, working paper 136, International Monetary Fund, 2008). We suggest rationalizing social spending and devoting the country’s revenue to necessary and economically productive projects. The efficient use of resources will thus ensure better quality of education and health care services. This calls for good governance, an adequate administration and effective delivery structures.